Outdated 4% Rule Doesn't Allow You To Maximize Your Income in Retirement
I’m straying a little bit from The Double Play theme in this post. I want to cover a quick but very useful topic: “How much savings do I need to retire”? I’m not going to address “how much income” you will need in retirement. That is a very nuanced subject and many books have been dedicated to that subject. Instead, I want to show you a couple of simple tricks to convert that income requirement to the amount of savings necessary to generate that amount of income. So if this sounds interesting to you, keep reading.
Main Goal Of This Article
The goal of this post is to show you a few simple Rules of Thumb that can be used to calculate the amount of savings necessary to generate a target income in retirement. I want to show you how the 4%-Rule and the 8% -Rule can be used to back into a savings requirement.
While the main thrust of this post is to show you how to calculate the amount of savings needed, I will spend a little bit of time covering the basics of Income Planning. Then I’ll explain how the 4%-Rule and the 8%-Rule can be used to calculate savings requirements.
Income Planning Basics
So rather than re-invent the wheel, I’m going to direct you to an E-book that I wrote several years ago. I wrote a “Financial Checklist For Cruisers”. As an avid sailor, I wrote this to help would-be Cruisers plan to cast off the lines. While it is geared toward Cruisers, the basic financial planning steps are still the same for traditional retirement income planning:
When do you want to retire? i.e. How many years do we have to save?
How much income will we need to sustain our desired lifestyle?
Duration of income.
How much savings do you need?
How much must you save annually to get there?
Number 2 is probably the most difficult step. Since we may be talking about costs 20 years in the future, we have to factor in inflation. Inflation is an unknown. All we can do is make a conservative guess. You also have to think about what kind of lifestyle you want in retirement. How are you going to keep busy? Will your mortgage be paid off? Will you still have kids at home or in college? The bottom line is you must simply come up with a conservative guess.
Number 4 on this list is what we are going to focus on in this post.
The Outdated 4%-Rule
Financial Advisors use The 4-Percent Rule as a Rule-of-thumb for determining the safe withdrawal rate from retirement savings. You want to take as much in income as you can, but you don’t want to run out of money while you are alive. Don’t take my word for this. Go out and do a search on “The 4% Rule”. If anything, the consensus nowadays is that 4% is too high.
What is the 4%-Rule?
An example of the 4%-Rule is that if you have $1,000,000 in a 401(k), for example, then the safe withdrawal rate from your 401(k) is $40,000 per year. $1 Million times 4% equals $40,000. But it is important to keep in mind that money in a 401k has not been taxed yet. That means that the $40,000 distribution is going to turn into $30,000 of net income after tax if you have a 25% effective tax rate.
It is also important to understand that the 4%-rule prescribes an amount that can be withdrawn each year based on the amount of savings at the time you retire. Using our $1 Million example from earlier, $40,000 is the safe withdrawal rate. But imagine that the year is 2006 and you are retiring and you kept your assets in the market because it was hot and you thought it would continue forever.
But remember, this is just before the 40% market crash and economic collapse. By 2007 your retirement savings is down to approximately $600,000. $40,000 now represents a much larger percentage of $600,000 than 4%. That annual $40,000 distribution takes a much bigger bite out of your remaining assets. The 4%-Rule tries to account for market crashes like this, but it may or may not work in reality. In fact, it would not have worked after the 2000 – 2002 crash. This is why experts think the 4%-Rule should be adjusted downward. See the earlier footnote.
How Does It Work?
So how do we turn the 4%-Rule into something we can use to determine the amount of savings that we need? Easy! If $1,000,000 times 0.04 equals $40,000, then all we have to do is divide our target income by 0.04 to arrive at the amount of savings we would need.
For example, if you needed $100,000 of income per year and retirement, Then you would need two and a half million dollars of savings according to the 4% rule. $100,000 ⨸ 0.04 = $2.5 Million.
You should also realize that the 4%-Rule doesn’t factor in inflation. From a planning perspective, by all means try to save up enough to generate your target income. But it is important that you think about saving even more to account for inflation. Inflation will slowly erode the purchasing power of a fixed stream of income.
What is the 8%-Rule?
The 8%-Rule is much like the 4%-Rule, but it only applies to maximum over-funded cash value life insurance policies i.e. a Life Insurance Retirement Plan (LIRP). You may wonder how life insurance can provide twice as much income from the same amount of money. The one thing that I think is very powerful, is that you do not TAKE any money OUT of a life insurance policy to generate income. You take advantage of the ability to borrow against the policy to access your cash value tax-free.
It is also important to understand that taking income via policy loans is the reason that the income is tax-free. You do not pay tax on money that you borrow. So unlike a traditional retirement account, where the money is physical taken out and distributed to the account owner, and taxed, in a LIRP, the cash value is not distributed. To get income from a life insurance policy, you take a policy loan.
It is important to realize that the cash value of a life insurance policy serves as the collateral for a policy loan. This means that the insurance company is loaning THEIR MONEY with your money remaining in the policy. And since the Cash Value remains in the policy, it continues to earn dividends or interest crediting. This means that the cash value balance continues to increase every year. This means that a maximum over-funded policy can generate much more retirement income than a traditional retirement account.
For the 8%-Rule to work, it is assumed that there will be at least 1% of positive interest rate arbitrage. This is the difference between the rate of growth on the cash value (Dividend or Interest Crediting Rate) and the loan rate on policy loans.
You may wonder if this 1% Arbitrage is reasonable to assume. You should be aware that Life Insurance Companies have a very long investment horizon. They expect to pay claims at the end of someone’s life. So while they need to have liquidity for current claims, they are primarily investing for very long hold times. This means that they can capture a premium for liquidity. Loan interest rates, on the other hand, are tied to the Moody’s Corporate Bond Yield. The difference between the Loan Interest Rates and the dividend crediting rates has historically been greater than 1%.
For example, Mass Mutual is currently paying a 6% dividend on their policies. Mass Mutual offers a variable loan option at 5%. This allows for a 1% arbitrage. Indexed Universal Life crediting rates have historically been several percent over the variable loan rate options offered by carriers offering those products. Just be mindful of the fact that IUL crediting will vary based on the underlying index performance. It is important to use dollar cost averaging and spread the cash value out across multiple indexing strategies. This will minimize the risk of negative interest rate arbitrage in any given year.
However, the 8%-Rule does take variable interest crediting into account. A LIRP can withstand a year or two of zero percent crediting.
How Does It Work?
Just as with the 4% rule, We divide the income requirement by 8% to arrive at the amount of cash value necessary. For example, if you needed $100,000 of income per year and retirement, Then you would need $1,250,000 of cash value according to the 8% rule. $100,000 ⨸ 0.08 = $1.25 Million.
Again, the 8%-Rule doesn’t factor in inflation. From a planning perspective, by all means try to save up enough to generate your target income. But it is important that you think about saving even more to account for inflation. Or simply take less than 8% annually to allow some room to increase the income to keep up with inflation. Inflation will slowly erode the purchasing power of a fixed stream of income.
The goal of this post was to show you how you can use the 4%-Rule and the 8%-Rule to estimate how much savings you would need to achieve your retirement income goals. While determining the income requirement in retirement was not the goal of this post, I did provide some guidance and a link to an e-book I wrote on this subject. Both the 4%-Rule and the 8%-Rule can be used to determine the savings requirement necessary to generate a target income. This is done by dividing the income by either 4% or 8%. As you hopefully noted, it is clear that cash value life insurance can generate more after tax income.
Two Economic Powers Approach to Maximizing Income in Retirement